STRENGTHS

WEAKNESSES

Highly dependent on large financial sector

Economy vulnerable to euro zone economic cycle

Future fiscal impact of ageing population

Risk assessment

Growth still buoyant

Luxembourg's growth rate is still one of the highest in the euro zone, remaining strong in 2016, despite a volatile quarterly profile, driven by stronger job creation, ongoing weak inflation and favourable financing conditions. A slight acceleration in activity is foreseeable in 2017, reflecting the implementation of fiscal reform comprising a significant cut in tax on individuals and businesss. In addition, employee wages are expected to benefit from the activation of automatic index-linking of wages to inflation at the end of 2016. This is likely to drive up GDP, even if some of these gains will be saved and used to purchase imported goods. At the same time, the relatively low unemployment rate is projected to remain in the region of 6%, while inflation is expected to increase with oil prices rising again.

At sectoral level, recent developments reflect a recovery in financial services activity, the traditional growth driver, after a chaotic start to 2016 due to market volatility. Worth noting too is a degree of dynamism in non-financial services, construction and industry (espeically aeronautics and satellite technologies).

The government's diversification strategy is aimed at promoting the development of new sectors (automobile parts, eco-innovation, health and biotechnology, IT and communications, space technologies),better arming the economy against shocks and improving job prospects for lower-skilled workers. On the other hand, the country's attractiveness could suffer from the process of international financial harmonisation and transparency currently under way.

A top-level financial system

The current account balance still shows a strong surplus, despite an income balance deficit, due to the existence of a sizeable services balance surplus. This is because the Grand Duchy is the second largest investment fund centre in the world, after the United States, and a central location for banks specialising in managing intra-group liquidity as well as the main centre for private banks in the euro zone. Furthermore, it is home to a great many reinsurance companies. While financial services play a major role in the economy (1/4 of GDP, 18% of budgetary revenues, 11% of employment), the process of harmonising financial standards within the European Union and at international level (automatic exchange of tax data regarding deposits in 2015 and end of bank secrecy by 2017) could threaten the attractiveness and profitability of the Luxembourg financial sector. This process will require the sector to readapt to a new regulatory environment (Banking Union, Basel III), which should help increase its resilience.

Nonetheless, the strong connections between Luxembourg's financial system and the rest of the world make it a receptacle (and also a vector) of global financial instability. Meanwhile, the level of exposure to the property market among the banks positioned on the domestic market still needs to be monitored.

One of the healthiest budget positions

Public accounts continued to show a surplus in 2016 due to firm revenues in a context of vigorous growth, a contained rise in spending associated with the multi-year fiscal consolidation introduced in the 2015 budget. The accounts should be in balance in 2017 thanks to the tax reform taking effect early in the year and which is expected to reduce State revenues by about 0.8% of GDP. At the same time, the reform of European VAT on e-business services will continue to generate a shortfall in tax revenues. The public debt remains one of the lowest in Europe (in addition, public sector assets exceed liabilities). The main challenges for the public finances continue to be the implementation of international fiscal transparency and, in the long term, the rising cost of the aging of the resident population and of cross-border workers.

Tripartite coalition losing popularity

The early elections held in October 2013 led to the formation of a new coalition including, for the first time, Liberals, Socialists and Greens led by the Liberal Xavier Bettel.

The coalition, already weakened by the massive rejection in June 2015 of the proposed constitutional changes (including granting the right to vote in national elections to foreign nationals resident in Luxembourg), continues to suffer falling ratings in polls to the advantage, mainly, of the former dominant party in the country's political history, the Christian Social People's Party.

That party, although the government is hoping to get the credit for the healthy state of the economy and its tax reforms, could lead the next coalition to come from the elections in October 2018. The continuity of economic policy would not be undermined.